Tax Cuts Make DRIPs Hip

When Congress tightened the spigot on dividend taxes it made DRIPs more attractive.

Netstock Direct, a Web site that focuses on DRIP investing, reports that traffic has picked up substantially since the tax cuts were signed into law May 23. And Chuck Carlson, editor of the DRIP Investor, says readership of his newsletter is also on the rise. "Anecdotally, we've noticed interest increasing over the past 12 months," he says. "Our newsletter is doing the best it's done in the past three years."

DRIPs are an easy and inexpensive way for small investors to buy and own stock. All you have to do is buy one share and the plan automatically reinvests the dividends you earn into more shares. Because most companies pay dividends quarterly, your portfolio grows every 90 days without your having to lift a finger.

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But even though you never see a check, you are still taxed on the dividends you earn. Because dividends were taxed at your highest income tax rate you were essentially paying taxes on income you never saw. Now that the top dividend tax rate has been pared to 15% (5% for investors in the two lowest brackets), that tax bite is a lot less painful.

About 1,400 companies offer dividend reinvestment plans. And Carlson expects that number to grow over the next couple years, as demand increases. Microsoft (MSFT), for example, paid its first dividend earlier this year and set up a DRIP program. "We're going to see the diversity of companies improve from not just the old-line industrials or blue chips, but to more faster-growing companies," Carlson says.

You can find a list of companies offering DRIPs at DRIP Central and Netstock Direct.

Pros and cons of DRIPs

DRIPs have their downside: You can't buy and sell when you want (sometimes only weekly or monthly) and preparing your taxes can be a nightmare because each company's plan is administered separately. But DRIPs have several key advantages:

• Small dividends buy fractional shares, a boon to small investors.
  
• Many DRIPs let you make additional investments on your own. A handful of companies sweeten the pot further by offering DRIP shares at discounts of 3% to 5% from the market price, although few permit the discounts on additional purchases. (The amount of the discount is included in your taxable income in the year of purchase.)
  
• You reduce risk by investing via a DRIP because it's a form of dollar-cost averaging.
  
• Plan fees are small compared to brokerage commissions. For example, you might pay a maximum $2.50 administrative fee per transaction, or $1 to $15 if you want possession of stock certificates.
  

How to pick a DRIP

Look for stocks with good track records of steadily rising dividends. (For more on picking dividend-paying stocks, see How to Pick Stocks That Keep Paying.) Companies that offer DRIPs also have outstanding dividend-raising records include Pfizer (PFE), ExxonMobil (XOM), and Puerto-Rican holding company Popular (BPOP).

Get a copy of the plan prospectus and be sure you're clear on the rules, and keep it handy for reference purposes. Remembering the rules of each plan can be confusing if you belong to several.

If you plan to invest additional cash through a DRIP, be sure to check on investment limits. Some companies will let you kick in as little as $10 per month. Others have higher minimums. Maximums range from $1,000 to more than $5,000 per month.

Keep your eyes open for extra fees. Some plans, for example, charge a fee for each additional cash purchase. The Moneypaper lists companies that charge no fees to DRIP investors.

Getting in and out

Joining a DRIP is easy. Check the company's Web site or call its shareholder relations department for a prospectus and application, and send back the completed form.

Often, you must already own some stock before you can sign up. You can buy your first shares through a broker, register the stock in your own name, and then transfer it to the DRIP. A small but growing number of companies will handle an initial purchase directly.

DRIPs can be a drag when it's time to sell. Some companies permit investors to sell their shares via the telephone or in writing, and they send you the proceeds. But other firms mail you a stock certificate, which you must then sell through a broker. A few also limit selling to specified amounts, such as 100-share lots. But selling needn't be troublesome if you think ahead.